ThinkingCap

Annual Commentary
2006 Hemant Sreeraman (hemant.sreeraman@gmail.com)

As the curtains come down on yet another eventful year in the Indian equity market, I think the time is right to put down my thoughts. In this commentary, I shall write on the broad factors that influenced market direction in 2006. I shall not use too many jargons, as I believe they kill the fun of reading. (However, in places where I cannot avoid some, explanations follow). In connection with this, I shall write on what fuelled the growth in stock prices of companies and prices of real estate. I shall also write on the factors that I think keep foreign investor interest high on Indian equities. As usual, I shall refrain from making any prediction about market direction or market levels. I believe that predicting market direction is far less fruitful than predicting my behavior, simply because I have far more control over the latter.

What happened to the Indian stock market in 2006?
Economic Data: India (2005) Population (Billion) GDP (PPP in $ Trillion) GDP (Per Capita in $) GDP Growth Rate (%) Inflation (Consumer Prices in %) Exchange Rate (Re/$; average)
Source: www.economist.com

1.1 3.8 3,508 8.4 4.2 44.1

Some comments are worthy here. The encouraging trend of the services and manufacturing sectors showing strong growth indicates several things. The former captures growth in trade, hotels, transport and communication. Companies that cater to these industries, not surprisingly, made their shareholders very happy. Before this section peters down to a numerical exercise, I shall introduce briefly on the implications of a growing economy on individuals and companies. This, according to me, is of far more importance than dwelling on numbers. So let’s dive right in. During an economy’s expansionary phase, interest rates tend to be low, thereby leading to an increase in what experts call, ‘credit offtake’ (a jargon that can be loosely replaced with ‘loans’). The low interest rates imply that individuals like you and me can borrow more than we previously imagined. This leads to growth in loans, which is positive for banks and financial institutions. Low interest rates also mean that companies can access low cost capital for capacity expansion. A growing economy also increases demand for

1.1: Macro factors strong The Bull Run that began in 2002-2003 showed no signs of abating in the year gone by. The macro economic factors strengthened further, propelling India’s GDP (Gross Domestic Product) to an 8.4% growth over 2005. In the latest quarter (Jul-Sep 06) the economy grew a whopping 9.2% over the corresponding period last year. Significant contributors to this growth were the Services sector, which grew 14% followed by Manufacturing, which posted a growth of 12%. Agriculture though proved to be a laggard, growing a meager 2% over last year.

Hope…can’t substitute Reason.

ThinkingCap
Annual Commentary
2006 Hemant Sreeraman (hemant.sreeraman@gmail.com)

goods and services. There are two major implications of this. The first, affects companies and stock prices and the second, inflation. I shall address both. A growing economy benefits companies as demand goes up for goods and services. This results in companies using their capacities to the hilt to cater to the burgeoning demand. This virtuous cycle reaches a stage where companies find that they have to add to existing capacities to cater to the ever-rising demand. Couple this with a low interest rate scenario (discussed above) and one sees why it’s a terrific time for companies to embark on capacity expansion. This is what’s happening in the Indian markets of late. The process, which began roughly in the 2nd half of last financial year, has picked up momentum now. One can expect this to continue through the next financial year as well. The second implication, inflation, is of a far more serious nature and affects companies and individuals to a great extent. We’ll look at the effects of Inflation through an example. After an economy gets into a hellhole, Mr. Inflation goes off to sleep. Nobody wants him. Why? People are laid off; incomes are cut or greatly reduced, leading to a drop in demand for goods and services. As demand falls, companies that produce goods and services are forced to cut the prices they charge customers. Else they are stuck with a lot of unsold items in their inventory. This leads to deteriorating corporate performance. Seeing the slackening performance, investors cash out. They are discouraged by the lull in the economy and refrain from committing any more capital into the stock markets. This leads to a fall in the stock prices of companies. People start thinking more about the basic necessities than luxury…

Whew…the bottom line of the exposition is that, demand falls, price falls and Mr. Inflation (which can be defined as the general price level) goes off to sleep. Seeing an in-the-hellhole-economy the powers that be decide to cut interest rates and push reforms. The cut in Interest Rates sets off a virtuous cycle that I had written about in earlier paragraphs. With time, the economy picks up and eventually starts booming…and wakes up the fast asleep Mr. Inflation. Mr. Inflation then grows from strength to strength until a stage where the same powers that be – which were in a way responsible for waking him up – fall over one another to put him back to sleep! They realize that if left unchecked, Mr. Inflation is capable of bringing an economy to its knees. This causes Interest Rates to go up, which gradually sets the stage up for the scenario played out three paragraphs above. Mr. Inflation eats ‘up’ the purchasing power of your money. For instance - assuming an inflation of 5% - a thing that costs Rs.100 today would cost Rs.105 a year hence, due to Mr. Inflation. This is also one reason why investments are so important. They help one in keeping ahead of Mr. Inflation’s reach. A return of 10% before inflation is taken into account would turn into 5%, after giving Mr. Inflation his due (5%). Getting out of story mode, Inflation today is a definite concern for the powers that be (we’ll call them RBI). Recognizing the effects inflation can have on the economy they decided to hike the Interest Rates. The implication of this is easy to see by now. Higher rates mean lesser borrowing by individuals. Highly leveraged companies will feel the pinch, as their interest costs will be higher.

Hope…can’t substitute Reason.

ThinkingCap
Annual Commentary
2006 Hemant Sreeraman (hemant.sreeraman@gmail.com)

This leads to a drop in net profits and EPS, assuming for an instant all other factors are constant. Dropping EPS means lower stock prices on the same P/E (Price = P/E x EPS). The net effect of all this is that the economy is prevented from over-heating and imploding. While this is a good effect, the market reactions to interest rate hikes is mostly knee-jerk in nature. Among other factors, an interest rate hike in May-June 06 was enough to send the market southwards by 25-30%. On balance the RBI, while being optimistic about economic growth is also silently worried about the negative effects of inflation. I believe that there is some more interest rate tightening down the road, especially if inflation continues unabated. After the super performance in the latest quarter, GDP forecasts for India have been raised to 8.7% for 2006-2007. Put in superior corporate

governance and reporting standards (although one could do with a bit more here!) and high ROE, and it is easy to see why FII are interested in the Indian market. 1.2: Thoughts on the market
10k..11k..12k..9k..10k..11k..12k..13k..14k?

That is the sequence the BSE Sensex traced broadly during the last year. After beginning the year at 9000 odd levels, the Sensex rise continued rapidly, fuelled in no small part by eager FII. Suddenly everyone was looking closely at Indian markets. The good GDP figures, coupled with reasonable inflation, good general corporate governance standards, high Returns on Equity (ROE), were enough to make FII embrace Indian equities. Companies were beating analyst expectations pretty consistently and this led to stock upgrades. An illustration is in place.

Analysts upgrade estimates

Companies beat expectations

Institutions load up on equities

More FII follow suit. Very bullish on equities
Figure pertains to Section 1.2

Hope…can’t substitute Reason.

ThinkingCap
Annual Commentary
2006 Hemant Sreeraman (hemant.sreeraman@gmail.com)

This cycle, which began in 2003 continued and lot of foreign money flowed into India. A we-willnot-tinker-too-much stance from the Finance Minister in the Union Budget didn’t upset the applecart. One could hear the, “long-term growth story is in place” almost everywhere. It seemed little could go wrong… And then the crash came… In a matter of weeks the markets tanked 25-30%. The reasons behind the fall in itself is an interesting and vast topic best relegated to a discourse elsewhere and at some other time. Part of it came about from the rate hikes and part from over-leveraged individuals and FII who wanted to extract maximum bang for their buck invested in Indian equities. If you are wondering why there is the odd blue shading in this section title, it is for good reason. The fall was one of the best times in years to buy into stocks of companies. Temporary stupidity and over reactions presented a golden opportunity to buy pieces of fantastic businesses at attractive prices. This was the best time to go stock shopping. In a knee jerk reaction, the markets dumped businesses, which had got better over time. However, sanity prevailed and the markets began its trot towards 14k with aplomb, turning people bullish along the way. No sooner had it touched 14k that ‘experts’ were predicting 15k before March 07. And then the crash came…once again… The CRR (Cash Reserve Ratio) hike in December gave the Sensex the shivers and it crashed almost 1000 points in 3 days. This is what transpired during the fall. A day by day walk

through. First day – Down 200 points Everyone said it was a ‘technical’ correction and there was nothing to worry about. Second day – Down 400 points About 30% of the people who opined on the first day turned ‘mildly bearish’ and suddenly began theorizing about how ‘hot’ Indian equities were. Third day – Down another 400 points This was enough to provide ‘proof’ for the Bear Hypothesis. About 60% of the people from the first day became bearish. They started predicting a bigger fall in the days ahead and took money out of the markets. Fourth day – Up about 200 points Ah! The long-term growth story was in place still, wasn’t it? The fall was just FII ‘churning’ their portfolios during year end. There was nothing to worry about. Thinking about buying (and changing

opinions)

Fifth Day – Up (some 3 figure points) The long-term India story is…let’s Buy! Sixth Day – Up…well… The lon…BUY BUY BUY! It seems like I love taking a dig at directional traders. That digresses from a larger issue. I cannot fathom how quickly the ‘experts’ alter their opinion about the markets based on how markets move, not on how the underlying businesses that represent the stocks they hold move. A continuous fall gets them itching to sell, even when the businesses are on sound footing. It also reflects the ultra short term outlook most people have when investing in equities.

Hope…can’t substitute Reason.

ThinkingCap
Annual Commentary
2006 Hemant Sreeraman (hemant.sreeraman@gmail.com)

The general feeling I get from my interactions with people is that most hold the view that trading is counter productive. But they just can’t seem to hold off the urge to trade. The verbal volleys around them entice them to do something that they shouldn’t be doing. And trading is a zero sum game. The broker and another lucky trader

on the other side of the trade get richer as the individual gets poorer. An illustration is appropriate here…

Most sell because the technical indicators scream a sell and they buy later for the same reason, after some ‘direction’ has been established. What they fail to take into account is the charges that are involved in the trades. Sure they aren’t very large but they exist. And more often than not, the subsequent buy is higher than the sell, and if unfortunately, the market reverses direction to move down, the losses magnify. Nobody can predict tops or bottoms in the market. But a ‘businessesque’, as opposed to a ‘traderesque’, thought process would have

indicated buying more of the stock during the fall. The costs are less and if indeed the markets moves up the investor makes a lot more money. The losses mount if the markets continue their southward journey, but a staggered buying takes care of this problem to a large extent. The crux here is…conviction. The common retort that people give to this is, “how does one know what a business is worth?” Sure that is a difficult question to answer. But if one cannot answer that then, in my opinion, it doesn’t make any more sense to trade, again

Hope…can’t substitute Reason.

ThinkingCap
Annual Commentary
2006 Hemant Sreeraman (hemant.sreeraman@gmail.com)

based on some indicators which the investor knows as much about as he knows about businesses!

eat my words next year!)

people to ‘lock in’ to their real estate investments at current levels. I think caution is the buzzword here. (I may have to

1.3: Thoughts on Real Estate
The year saw maddening investor interest in real estate. Suddenly from nowhere, stocks of real estate companies soared to the heavens. It seems the rising stock prices lead to a rise in the estimates of land banks owned by real estate companies! DLF’s mega IPO was scrapped due to adverse market conditions and is slated to hit the markets soon as conditions are better. Some other IPOs got phenomenal responses and, not surprisingly, saw their listing prices soar, making promoters and investors very rich. Looking at this scenario, I think investor expectations have run ahead of reality. The prices have been bid up so high that it will take a superlative performance from the real estate companies to justify the valuations. A big question mark hangs over my head on this issue. I hope investor expectations do not encourage companies to resort to creative accounting to meet expectations. I have paid dearly for keeping out of this space during the last year. But I hold my view and will not enter this space in the near future. I don’t want to get caught waiting for a greater fool to bail me out. However, my feeling is that investor interest will continue to remain high in the coming years and prices might go up further. A plethora of real estate funds slated to hit the markets may only exacerbate the situation. As a sidekick, I feel real estate prices have also moved up far too quickly in certain areas. A combination of over optimism and fear is forcing

1.4: Conclusion I think a combination of concerns over inflation and optimistic outlook towards Indian equities will usher in a new year. The nearing elections will probably see the government trying to juggle political and economic considerations. Petrol and diesel prices have already been slashed. While this is good from a political standpoint, it’s a disservice to economics. The sooner the government realizes it the better it is for the economy. Apparently the Indian market has an 80% correlation to the S&P 500 index. Almost everyone is portending gloom and doom for the US economy. It will be interesting to see how the Indian market will react, should a slowdown really occur in the US. Whatever the outlook, the markets will provide opportunities to buy chunks of great businesses at attractive prices. I prefer to wait till then
(and indulge in investing astrology if the markets are unkind enough not to provide me with any opportunities!).

Hope…can’t substitute Reason.

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